A distressed allocation can complement private equity and private debt strategies in the later stage of credit growth cycles as a record-high percentage of below-investment grade loans may create interesting investment opportunities, especially for non-performing loans, said the co-chairman of the US alternative investment manager Canyon Partners.
Corporate credit growth has accelerated to $11.9 trillion from $5.4 trillion since 2007 globally, fueled partly by a record amount of private equity capital raised over the past five years. A record amount of PE capital was put into the loan market during the period, according to the Los Angeles-based investment house.
In particular, low quality credit grew at a faster pace, with loans provided to B plus to CCC minus companies totaling about $1.4 trillion, up from about $600 billion in 2007.
“We think a distressed allocation can function to some degree as a hedge on PE/PD strategies, because in distressed environments there can be very compelling entry points to purchase deeply discounted debt of busted LBOs, to offer rescue financings to prime existing creditors, etc.” Joshua Friedman, co-founder and co-chairman of Canyon Partners told the Korean Investors.
“Distressed can be a fitting complement to them, particularly in the later stages of a cycle.”
Among industries, he picked offshore drilling as an example, where Canyon believes the value and investment horizon of those assets is longer than the market thinks.
On real estate, “build to core” strategies continue to offer structural alpha due to substantial demand from core buyers seeking stable yield, Friedman noted, citing the supply/demand imbalance caused by tighter lending regulations on new developments and elevated construction costs.
In Japan and South Korea, corporate governance reform is likely to offer investment opportunities. For Korean companies, he saw opportunities for special situation lending.
Canyon Partners is a multi-strategy alternative investment manager with strengths in distressed and special situations investments and manages $26.2 billion in assets.
It was founded by Joshua Friedman and his Harvard roommate Mitchell Julis in 1990.
The following are key comments from Mr. Friedman in a recent interview with the Korean Investors:
Q: What’s your view on the current credit cycle? Are we near the end of the cycle?
“The short answer is I don’t know exactly where we are in the cycle … but there are a number of cautionary signs out there, from the inverted yield curve to declining CEO confidence to plummeting IMF growth forecasts, etc.”
“But beyond these highly visible issues on the surface, there are others that keep us up at night and make us believe it’s prudent to keep some dry powder around.”
“For instance, new issue loans have never featured higher leverage, more adjusted leverage via add-backs, less debt cushion or weaker covenants.”
“Potential for the high-yield market size to swell “organically” is high. Over the past 10 years, non-financial BBB market has grown by 180% from $655 billion to $1.9 trillion. Total BBB market is about $2.7 trillion.”
“In previous distressed cycles, anywhere from 25-45% of the BBB Index has been downgraded to HY status… if downgrades in the next cycle resemble history at all, the dollars amounts could be staggering.”
Q: At this stage, where are the segments in the market that offer the most attractive investment opportunities?
IN REAL ESTATE
“We are focused on fully entitled build-to-core, as that is where there is a supply/demand imbalance in capital availability thanks to regulations on banks… Particularly focused on multifamily (apartments) in major cities, as there has been very little development since the GFC relative to household formation.”
“We have been lending at around 15% yields at about 64% LTVs– this is about 800-900 basis points wider than the “B” portion of the HY Index. I don’t see much better risk/reward out there, and the assets we’re financing can take a beating on valuation before we begin to feel it. In general, we find this kind of direct lending to have much higher quality underlying assets than the SME corporates being financed by direct lenders.”
IN HEDGED INVESTMENT STRATEGIES
“We’re focusing on short duration, idiosyncratic investments such as merger arbitrage, bespoke bridge-like financings and other event-oriented credit situations.”
“These kinds of investments tend to turn to cash quickly on their own. About 25% of our portfolio turned to cash last year, excluding sales. This limits our exposure to potential turns in the cycle and gives us a constant stream of fresh cash to deploy or set aside for a rainier day.”
IN DISTRESSED INVESTMENT STRATEGIES
“We’re focused on some industries that have been left for dead, including offshore drilling, but where we believe the value of those assets and duration of those assets is longer than the market thinks.”
“We have also been consistent providers of large-scale primary capital solutions to companies that need to address certain balance sheet needs.”
Q: Please highlight how a distressed investment strategy fits within a traditional corporate alternative investment portfolio.
“We think a distressed allocation can function to some degree as a hedge on PE/PD strategies, because in distressed environments there can be very compelling entry points to purchase deeply discounted debt of busted LBOs, to offer rescue financings that prime existing creditors, etc.”
“At the end of the day, PE/PD can be great strategies, but distressed can be a fitting complement to them, particularly in the later stages of a cycle.”
Q: What are the major risks of distressed investing? What are the key factors to consider when investing in distressed assets?
“Understanding and pricing litigation risk is a critical component of distressed investing, whether in conventional bankruptcies or liquidations like Lehman Brothers.”
“On liquidity, there are far fewer buyers of distressed assets than conventional assets. That’s part of what creates compelling distressed discounts… This is why locked-up private equity style capital is so important.”
Q: What’s your strategy in Asia, especially Korea?
“Corporate governance reform in markets like Japan and Korea offer opportunities for balance sheet optimization and shareholder-friendly activity.”
“Specifically in Korea, we have seen a few special situation lending opportunities for Korean companies that can’t get traditional bank financing.”
By Jung-hwan Hwang & Chang Jae Yoo
<Edited by Yeonhee Kim>